The horizon is not so far as we can see, but as far as we can imagine

How Futures Affect the Price of Oil

Since oil prices are being discussed again, I am re-posting this article from July 23rd, 2008 on how oil prices are actually determined.

Oil Barrel

Much as I hate to disagree with Krugman, his thesis that oil futures have no effect on oil prices is one that I believe is incorrect. On the face of it Krugman should be right — why should a bet on the future direction of oil prices have any effect on the price today? If I bet it’ll go up 10 bucks in a week and you bet it won’t, and at the end of the week we settle that bet, did that have any effect on the price of oil? Of course not. And, essentially (but not quite) that’s what futures and options do. Oh, with futures you can take delivery, but most people don’t, they close out the contract before it comes due. (Because what are you going to do when the tanker pulls up and wants to offload that crude oil? Hmmmm?)

But, in fact, the oil market doesn’t operate like normal futures markets. Let’s take Brent oil, which is the benchmark price used for most European, African and Middle Eastern oil. There is no actual spot market for Brent. A basic contract for Brent, called Dated Brent, indicates that the seller can deliver oil anytime during a specified month, and has to give 21 days notice to the buyer. In other words, a basic Brent contract is already a futures contract in some key aspects. (Mabro, 66). If the price increases, you’ve made money.  And if it declines, in effect, you’ve just lost money.

On top of Dated Brent, Saudi Arabia, Kuwait and Iran all use futures markets to determine the price charged to actual physical customers in Europe for oil. They take the Brent Weighted Average (BWAVE), a weighted index of futures on a given day, and use it to determine the price. (Mabro, 68-9). So the futures market is directly influencing the price of actual oil. They do this because, ironically, the old spot markets were very subject to price squeezes and futures markets, being much larger and more liquid, with more participants, were seen as harder to manipulate.

Now because of how arbitrage works, and because Brent oil can often be substituted for other types of oil, the price of Brent is hardly going to substantially differ from other types of oil. If it does, arbitrageurs will step in and close the difference.

All of which is to say, as best I can determine, yes, futures prices do factor into the actual price of oil. The “spot” market does not exist separate from the futures market in all cases, indeed, strictly speaking there isn’t even a Brent spot market in existence. The price is determined by futures or dated contracts that have features in common with futures.

Now, if a huge amount of speculation is driving up futures prices, which it is, that will feed back directly into the price of oil. So if you want to reduce the price of oil, decreasing the amount of speculative activity is a good idea. The Saudis, when they claim that speculators are partially to blame, aren’t being disingenuous, they’re telling a truth. Of course, it’s also true that futures markets have an effect on oil prices because the Saudis, among others, set up the market that way. Yet, if they were to change the pricing they’d simply move the speculation to the sort of physical storage that Krugman and others see little or no sign of. The effect is unclear, on the one hand it’s a smaller more illiquid market. On the other hand, you have to actually take delivery of the oil and hold onto it, and there’s only so much oil storage in the world, while the numbers of futures contracts which can be sold is theoretically infinite.

In general liberals should be for regulation of futures and options markets; for regulation of derivatives markets as a group. They do serve a legitimate purpose for hedging, but when they become much larger than needed for hedging, their original purpose tends be lost and they become a casino. Hedgers require some speculators to make the market, but they don’t require as many as they’re getting.

This doesn’t mean that speculators are responsible for the majority of the price increases in oil and gasoline. They aren’t. Fundamental supply and demand considerations are causing the price increases. Speculation, however, is making the rise more rapid than it would be if just driven by fundamentals alone. The easiest way to see a fairly quick drop in the price of oil is to crack down on speculation. However, such a drop will be temporary, not permanent. Until the fundamental problems of demand and supply are dealt with, oil prices will continue their long steady rise. That rise is a good thing, in the same sense that feeling pain when you’re on fire is a good thing – because it tells you “stop this behaviour”.

But having someone pouring oil on the fire while you’re trying to get out of it isn’t helpful, and that’s what speculators are doing. It’s very profitable for many of them to do so, but there’s no particular reason society should allow them to profit from the pain of others.


The Non Debate Between Krugman and Johnson


The American Death Wish


  1. Unemployed18months

    OT. Hey Ian, I am really impressed by your writing and the lack of advertisements on this site. It’s really nice to see someone who blogs and does not profit from it. It really helps your credibility. I graduated from college almost two years ago, and still have not been able to find a job other than a freelance gig here and there. I will be living out of my station wagon by the end of next month, but despite my uncertain future, today I feel a little better waking up to the knowledge that someone is in it for the people and not for the money or influence. Thanks, Ian.

  2. Ian Welsh

    Thanks U. I hope you find a job.

    I have nothing against ads per se, just can’t be bothered, honestly.

  3. Keith1234

    I am a speculator and a veteran of 36 years in the drilling and completion industry. As a speculator I am making a bet, if right I make money, if wrong I loose. Our short sighted society would run itself seriously short of oil if not for speculators. The price today sets the production capacity 2 years from now, if you set the price at 1000/bbl today, it would take the oil industry 2 years to ramp up production. If the world grows at 5% year for 2 years, oil consumption will be about 94 million bbl/day. That will cause a price spike.

  4. Thanks for this post, Ian. I’ve always found that your written analysis of these arcane subjects very helpful – you were one of my favorite front-pages at FDL.

    All butt-kissing aside, though ;), I’ve gotten out of my depth on occasion on this very issue. I’m kind of a Peak Oil nut, so I was always uncomfortable with those who just blamed the speculators for increases. And I see now that I have argued badly.

    That’s an excellent clarification of the relationship between the financial and the supply-and-demand aspects of oil economics. Can’t see how Krugman would quibble with it. Am currently internalizing these points until they are cocktail-chatter worthy. (Link for the 2008 article? It seems this post an updated version, no?)

  5. Ian Welsh

    I have added a link to the original article. It was not changed, other than the addition of introductory text, from the original article.

  6. Thank you, sir!

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